S Corporation Changes in the Small Business Job Protection Act of 1996
After months of political wrangling, in early August, Congress passed the minimum wage increase bill. Since it was perceived that the small business community would be most adversely affected by the wage increase, a number of tax law provisions were added to benefit companies with either a small number of owners or a small number of employees. Packaged under the title "Small Business Job Protection Act," this collection of changes was signed by President Clinton on August 20, 1996. One principal subject matter is the long-awaited reform and simplification of S Corporation law.
"S Corporations" are basically creatures of federal tax law. (They take their name from Subchapter S of the Internal Revenue Code.) Their special tax advantage is that company owners may enjoy the limited liability of a corporate shareholder while being taxed as a sole proprietor or partner. That is, in general there is only a single layer of tax on business income, at the shareholder level, rather than both a tax to the corporation as income is received and a tax to the shareholders as dividends and other distributions are made. Because this avoidance of "double taxation" was so exceptional at the time Subchapter S was adopted, rigorous limitations were established on the type of entities which might qualify for this treatment and their method of operation from a tax standpoint.
Over the years some liberalization of these rules took place. But since the late 1980s, there has been a legal development which threatens to make S Corporations irrelevant. As states adopted statutes permitting the creation of "limited liability companies" and "limited liability partnerships" (Wisconsin authorized the former in 1994 and the latter in 1996), business owners found other organizational forms which gave them limited liability with single-layer, flow-through taxation. And since these new entities are basically creatures of state law, they have none of the S Corporation restrictions; they only have to meet general requirements of partnership taxation. As a consequence, S Corporations have become the entity of choice in only a few situations:
- When the S Corporation tax restrictions are not burdensome in the specific circumstances, and the corporate form of operation is more comfortable than a partnership to the owners or managers.
- When an existing corporation has accumulated profits, and the owners wish to avoid double taxation on future earnings without generating an immediate tax on the past earnings. In such a case, use of Subchapter S is mandatory, since conversion to a limited liability company or partnership would be treated as a liquidation.
In this context, the current Congressional overhaul of S Corporation law is a clear attempt to catch up with the times.
The primary mechanism used by Congress to restrict availability of S Corporations is through limitations on the number and type of permitted shareholders. In each case the new law substantially eases these restrictions. Unless otherwise noted, all changes are effective for corporate taxable years beginning in 1997.
1. Permitted Number. The maximum number of shareholders which an S Corporation may have is increased from 35 to 75. (As in the past, married shareholders are treated as a single owner, regardless of how their shares are held.)
2. Electing Small Business Trusts. Under prior law, only two major types of trust are permitted to hold S Corporation stock: a "grantor" trust, in which the donor remains the owner of all trust assets for tax purposes; and a "qualified subchapter S trust" (QSST), in which a single individual is the sole trust beneficiary during his or her lifetime and in fact receives all trust income currently. In both of these cases there is one identifiable person who can be taxed on the S Corporation income, whether or not such income is actually distributed by the company. These restrictions represent a serious limitation on the estate planning alternatives available to families which hold S Corporation stock. Some common examples:
- The typical form of "single fund" family trust, in which income or principal is distributed among a class of beneficiaries based on age and need, is not possible here since each trust beneficiary must have his or her own QSST.
- A trust designed to skip one or more generations, while avoiding generation-skipping transfer tax, often will find the QSST mandatory income distribution requirement a substantial disadvantage.
The new act provides for a third type of eligible trust shareholder, an "electing small business trust" (ESBT). Basically, this is any type of trust as long as there is no beneficiary other than an individual, estate, or organization which qualifies for income tax deductible gifts. [For the year 1997, the described organization cannot be a potential current trust beneficiary; starting in 1998, that restriction is removed.] No interest in the trust may have been acquired by purchase. And the trust can be neither an existing QSST (which is taxed under the old rules) nor a tax-exempt trust (which is taxed in a different manner discussed below).
If an ESBT may have multiple current beneficiaries, including discretionary beneficiaries, to whom will the S Corporation income be taxed? The Congressional solution is to tax the trust itself. This is accomplished by segregating the S Corporation stock from other trust assets for tax purposes. Then the stock’s imputed corporate income, plus any gain or loss from the sale of the stock at the trust level, less any state taxes or administrative expenses specifically allocable to the stock, will be taxed at the highest current rate (now 39.6% on ordinary income and 28% on capital gains). It does not matter whether the trust actually accumulates or distributes any S Corporation income. At the same time, the other trust assets will be taxed as if they were in a separate trust, subject to normal tax flow- through rules if distributions are made to beneficiaries.
A second question is how the ESBT will be counted in determining number of shareholders for the 75-shareholder limit. In this case, somewhat inconsistently with the taxation conclusion, Congress decided that each potential current beneficiary of trust income or principal must be counted as a separate shareholder. Without some drafting forethought, this obviously could erode the newly liberalized limit quickly.
The ESBT is an entirely new tax creation. Whether it is desirable in any particular circumstance, notwithstanding the highest-bracket rate of tax, may take some consideration. At a minimum, it offers an estate planning option that every existing and potential S Corporation shareholder should keep in mind.
3. Extended Holding Period for Nonqualifying Transfers in Trust. Sometimes a shareholder will leave stock to a trust that does not qualify or does not wish to elect under the expanded rules. If the transfer is by will, or if the trust was a "grantor" trust before the owner’s death, then the trustees have two years (previously only 60 days) from the prior owner’s death to deal with this situation before ineligibility results.
4. Tax-Exempt Organization Shareholders. Since under prior law, only individuals, estates, and special types of trusts may hold S Corporation stock, it was not possible to make a gift of such stock to a charity or leave such stock to a charity after one’s death. The apparent rationale was that, although all S Corporations eliminate one layer of tax, Congress did not want this income to escape tax entirely – as would be the case if the S Corporation shareholder were tax-exempt.
However, for corporate taxable years beginning in 1998, any tax-exempt organization which is a "501(c)(3)" charitable organization may be an eligible shareholder. The potential no-tax problem is resolved by treating the S Corporation income as "unrelated business income" (on which tax-exempts normally must pay tax, at regular corporate rates). Also included as a taxable item is any gain or loss on the organization’s sale of the S Corporation stock itself. In this respect, if the stock is purchased by the organization rather than received by gift or bequest, the stock’s basis in the hands of the organization may be reduced by any corporate dividends actually paid. For shareholder count purposes, the tax-exempt organization is treated as only one shareholder (even if it is a trust).
The allowance of tax-exempt shareholders has another potentially beneficial consequence. In the past, an S Corporation could not sponsor an employee benefit plan which held its own stock. Now such possibility exists, as long as the trust holding the stock is part of a "401(a)" qualified plan. Again, the pass-through corporate income will be taxed to the trust as unrelated business income. In addition, under the "too much of a good thing" rationale, Congress made it unattractive to hold S Corporation stock in an Employee Stock Ownership Plan by denying ESOP contribution deductions and some other special tax features.
Beyond shareholder limitations, Congress has imposed a number of restrictions on the manner in which an S Corporation may be structured and conduct its operations. The new law makes some of these rules more flexible, and to that extent this does constitute "reform." Whether the announced goal of "simplification" has been achieved is much more doubtful. Some of the more significant tax liberalizations include:
- Invalid Elections and Consents. The Internal Revenue Service previously had authority to waive an inadvertent termination of the S Corporation election. Effective back to 1983, this authority now is extended to an inadvertent failure to qualify in the first place, including a failure to obtain required shareholder consents or simply to make a timely filing of the election. Conversely, if an S Corporation expressly terminated its election prior to 1997, it now may reselect S Corporation status without regard to the usual five-year waiting period for such reselections.
- Financial Institution as Creditor. Since S Corporations may have only one class of stock, it is important to know when corporate debt will not be treated as equity. In the past, under the statutory safe-harbor known as "straight debt," the creditor had to be a permissible S Corporation shareholder. It now also may be an institution actively and regularly engaged in the business of lending money.
- Ownership of Subsidiary. In a marked departure from the past, S Corporations now may own 80% or more of an active corporate subsidiary. This permits a second layer of limited liability for risky enterprises. The subsidiary’s financial results will not be consolidated with those of the S Corporation unless the former is a "qualified subchapter S subsidiary" (QSSS), consisting of another S Corporation solely owned by the parent S Corporation.
- More Partnership Rules Apply. As noted above, the purpose of an S Corporation is to provide an entity taxed in the general manner of a partnership. Nonetheless, in the past many specific rules of partnership taxation were not followed. The new law harmonizes some of these discrepancies (including, for example, basis adjustments during loss years, and treatment of income in respect of a decedent by persons acquiring S Corporation stock through inheritance). It also makes it easier to close the S Corporation books during a year in which an S Corporation shareholder disposes of his or her interest (a result which occurs automatically in a partnership). The deduction for a charitable contribution of S Corporation stock may have to be reduced by "looking through" to the underlying corporate assets, as in the case of a partnership interest, though there is no required reduction with respect to tangible personal property held by the S Corporation.
Whether there has been enough reform and simplification to reestablish an ongoing place for the S Corporation as a matter of new-entity planning is questionable; this is something the legal marketplace will decide. At least these changes may provide some relief for the existing organization which is effectively trapped in corporate form, and which for the first time can qualify as an S Corporation, or which already is an S Corporation and now can expand in previously prohibited directions.
von Briesen & Roper Legal Update is a periodic publication of von Briesen & Roper, s.c. It is intended for general information purposes for the community and highlights recent changes and developments in the legal area. This publication does not constitute legal advice, and the reader should consult legal counsel to determine how this information applies to any specific situation.